WP/09/65



Developing a Structured Forecasting and
Policy Analysis System to Support
Inflation-Forecast Targeting (IFT)

Douglas Laxton, David Rose,
and Alasdair Scott

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© 2009 International Monetary Fund
WP/09/65

IMF
Working Paper



Research Department

Developing a Structured Forecasting and Policy Analysis System to Support Inflation-
Forecast Targeting (IFT)1

Prepared by Douglas Laxton, David Rose, and Alasdair Scott

Authorized for distribution by Charles Collyns

March 2009

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

This paper presents a basic plan for developing a Forecast and Policy Analysis System
designed to support an inflation-forecast targeting regime at a central bank. It includes
discussion of the development of data management and reporting processes; the creation of a
forecast team and the development of human capital; the implementation of a simple model,
plus possible extensions; and the management of regular economic projections. We
emphasize that it is better to implement simple models earlier and use them well, rather than
wait in an attempt to develop an all-encompassing model.

JEL Classification Numbers: E5, Z0

Keywords: forecasting, economic projections, macroeconomic models

Author’s E-Mail Address: dlaxton@imf.org; ascott@imf.org

1 The authors wish to thank a large number of people in central banks that have provided comments on
earlier versions of this paper. Extensive modeling resources to support IFT regimes can be found at
www.douglaslaxton.org.

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CONTENTS Page
I. Introduction....................................................................................................................3
II.
Developing a Decision-Making Process........................................................................5
III.
Benefits of a Successful IFT Regime...........................................................................10
IV.
Critical Path For Developing A Structured FPAS .......................................................12
V.
The Quarterly Projection Exercise...............................................................................18
VI.
The Core Model ...........................................................................................................24
VII.
The Role of Models in the FPAS.................................................................................27
VIII. On the Evolution and Development of the FPAS........................................................33

Text Figures
1.
The Role of Models in the Forecast Process................................................................29
2.
From Policy Issues to Policy Recommendations.........................................................32
3.
How Several Models can be Combined to Impose Consistency .................................35

Appendix Figures
4.
A Possible Reporting Structure....................................................................................46
5.
Links Between Different Databases.............................................................................50
6.
The Monetary Policy Transmission Mechanism .........................................................52
7.
Inflation Expectations 10-Years-Ahead in the United Kingdom.................................53

Appendix Tables
1.
Estimation of a Model with Model-Consistent Measures of Potential GDP ...............63
2.
Notation: Time Periods Correspond to Calendar Quarters ..........................................64

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I. INTRODUCTION
Countries with experience implementing independent monetary policies in periods of flexible
exchange rates have had considerable advantages making the transition to explicit inflation-
forecast targeting (IFT) regimes. This is because they already had most of the systems and
expertise in place to support IFT. However, for countries facing a rapid transition from fixed
exchange rates to IFT, developing the internal monitoring and forecasting processes has been
more difficult.
This document provides a basic plan for developing a forecasting and policy analysis system
(FPAS) to support policy decision-making in countries that are considering (or have recently
adopted) an IFT regime. The suggestions are based on our view of ‘best practice’ for IFT,
and an assessment of how that practice could be transplanted to institutions that face
challenges of limited resources and fast-changing economies. We deliberately avoid
reference to specific institutions, because we think that no institution has a monopoly on
what constitutes best practice. While institutions that are new to IFT undoubtedly face
challenges, they are also free to consider the whole picture of what is required for IFT in
creating their own practices.
The proposed development strategy is based on a belief that many of the difficulties
associated with developing the systems and expertise required for IFT are usually the result
of two problems:
•
First, there may be an attempt to develop the perfect system too quickly, at the
expense of achieving a minimum acceptable degree of functionality in the short run.
•
Second, there may be an attempt to put too much emphasis on the model itself. An
effective IFT system requires considerable integration of its parts⎯the databases, the
reporting system, the forecasting process, the information technology, the
communication and decision-making framework, and so on.
Hence, while the system proposed here borrows greatly from the forecasting and policy
analysis systems that have been developed over the years in various central banks, it has
deliberately been kept simple. The system must focus on the needs of policymakers, but
always with a view to the resources available. It can and should be refined and extended as
time and resources permit. However, it is most important to start operating as quickly as
possible.
The goal of the paper is to outline systems and processes that help the staff of the economics

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departments in central banks achieve a coherent view of what is happening in the economy,
what the policy implications of that are, and what that implies for research and further
investigation.
More concretely, the proposed system involves the following parts:
1.
Developing a reporting, database, and near-term forecasting system based on a
limited but key set of macroeconomic variables, so that everyone involved in the
forecast and policy process can share the same information.
2.
Updating the database, monitoring and reports on a timely (weekly) basis so that
everyone involved in the process will be informed about how new information
affects the near-term inflation forecast (and the implications, if any, for the
longer-term outlook).
3.
Developing a simple quarterly projection model of the economy that embodies
policymakers’ views about the monetary policy transmission mechanism and the
standard set of shocks that affect the economy. The model may be very simple at
first; the important thing is to get a complete system operating quickly. The
model can be extended over time as dictated by experience, but the core
projection model should not be allowed to turn into a ‘black box’ by becoming
too complicated.
4.
Developing a consistent, model-based macroeconomic forecast every quarter.
This includes assessing the risks to the previous official baseline forecast and
using that to propose changes to the official baseline forecast.
5.
Developing measures of uncertainty in the forecast, such as model-based
confidence intervals. These measures should be used to communicate the extent
of this uncertainty, both internally and to the public.
6.
Studying specific risks in the baseline forecast and developing contingency plans
for reacting to new information that is released between official forecasts.
Inflation-forecast targeting involves using a wide range of information in order to obtain the
best forecasts for inflation and the economy. The staff must extract the underlying pressures
on inflation and the economy from data that may be conflicting and noisy. To foster the
necessary cooperative effort, all participants must be able to share information and to see
how new information⎯from themselves and their colleagues⎯affects the forecast.

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This is important because successful inflation forecasts are not mechanical; the principal role
of models is to see what implications these judgments about the state of the economy have
for policy. In fact, in the very early stages of an IFT regime, forecasting and policy analysis
may be based entirely on judgment, without the use of any formal model. The development
of the FPAS can be greatly advanced simply by developing a process for regular meetings
and reports, where the staff review recent economic developments and provide an assessment
of the risks to the previous baseline forecast. However, as the IFT regime evolves, it would
be useful to impose more discipline and structure on the policy debates by developing a core
macro model explicitly designed to support IFT. The model may therefore be a natural
extension of an existing process, but introducing a macro model in a situation where there is
no process for interpreting and reporting data outturns is not likely to be very helpful.
Similarly, it will be difficult for staff to introduce successfully the changes proposed here
unless their ‘clients’⎯the senior managers who make key policy decisions⎯are receptive to
the need for such a structured process. In what follows, we assume that this exists, but there
may need to be a preliminary process wherein upper management is introduced to the
processes described here and persuaded of their benefits. This may take some time, but it is
nonetheless necessary that staff and upper management approach building a structured FPAS
with a shared view of what is to be put in place and the ultimate goals.
The remainder of the paper is organized as follows. Section II discusses an internal process
for policy decisions with fixed, announced action dates and reports to the public. It also
reviews what information and analysis policymakers need to make informed and timely
decisions about setting the policy instrument. Section III explains the basic benefits
associated with a successful IFT framework and the specific benefits associated with
developing a structured FPAS. Section IV discusses the steps that are necessary in
developing such a system. Section V describes how the quarterly projection exercise could be
organized. Section VI provides an outline of a simple model that could be used for small
open economies, and explains some of the technical aspects about the forecast. Section VII
explains what would have to be done to develop the internal expertise to build more
sophisticated macroeconomic models for use in the FPAS.
II. DEVELOPING A DECISION-MAKING PROCESS
In a regime with a fixed exchange rate, there is no independent domestic monetary policy and
so no decision-making process is required, other than the day-to-day reaction to
developments in the exchange market and closely related financial markets. However, once
there is an independent domestic monetary policy, such as arises from an IFT regime, it
becomes imperative that there be a structure and process for monetary policy decisions. In
later sections of this paper, we will look at the details of the underlying FPAS necessary to
support monetary policy decisions. Here, we focus on the end result, the policy decisions,

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covering the information required, the nature of discussions and deliberations that will
facilitate the process and the nature of communication of the decisions to markets and the
public generally.
Different institutions have different internal decision-making structures. In some, the final
decisions on policy actions may rest in a single individual, a Governor of the central bank or
the equivalent. In others, there may be a group of senior managers charged with that task. In
our discussion, we will simplify the exposition by assuming that the decision-making body is
a Monetary Policy Committee (MPC). In this discussion, it does not matter whether the MPC
is a group or an individual.
Central to the success of an IFT regime is developing credibility that the monetary authority
will act to respect the announced inflation targets over time.2 A major benefit from earning
such credibility is that routine shocks will not have profound lasting effects; long-term
inflation expectations will remain anchored to the policy target and routine shocks will have
only minor transitory effects on markets. This ideal situation will not come immediately from
an announcement of a new policy regime. It will have to be earned and defended over time.
The only way this can happen is through clear and consistent communication of the policy
decisions and, most importantly, the reasons for them.
Information comes to policy decision-makers all the time. In financial markets, there is
something new every day. However, IFT policy decisions require a longer horizon and a
clear macroeconomic framework. In most countries, complete economic data in the form of
national and/or domestic accounts comes quarterly, with a lag of course. Yet, many partial
indicators are available monthly. In the sections that follow, we describe a system of
monitoring, forecasting and policy analysis that is structured around the flow of information.
This system is designed to provide for ongoing discussion of economic developments and the
implications for monetary policy that will take place continuously, and with some formal
internal discussion and summary at least once a week. Policy decisions based on such
ongoing discussions will be better informed and better communicated. However, that does
not mean that decisions need to be taken and communicated every week.
In recent years, many monetary institutions have moved to a fixed calendar of formal
decision dates and consequent communication with markets, with these dates announced in

2 This does not mean that the target must be hit. Indeed, that has zero probability in an uncertain
world. Moreover, in the face of difficult shocks, other considerations might dictate that ‘good’ policy
would imply not focusing solely on bringing inflation to the target as quickly as possible. The key to
credibility is to explain in detail the reasons for decisions and, in particular, to avoid any sense that
decisions are systematically inconsistent with hitting the targets.

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advance. Since we are discussing regimes designed to deal with inflation, there is a case for
using the release of data on inflation, typically monthly, to trigger the process of deciding
and communicating the results. Indeed, in some institutions, a full monetary or inflation
report is generated monthly. If that is desired and feasible, there is no problem. However, we
want to stress that neither the decision-making nor the communication need be tied to such a
demanding schedule. For countries entering into IFT decision-making for the first time, full
reporting on a quarterly basis, linked to the release of the domestic accounts, and a full-
blown update of the economic outlook and medium-term forecast, would be reasonable.
This does not mean that decisions should be taken and communication undertaken only at
these quarterly ‘full-report’ times. There could be a fixed schedule of monthly decisions
triggered by the latest inflation data (if available at monthly frequency), with a brief update
on economic and monetary conditions and the reasons for any actions taken, presented in the
context of an update on the previous quarterly report, in the months between releases of the
domestic accounts.
It is not essential that the fixed schedule be monthly. It is widely accepted that quarterly is
not often enough, but some countries have chosen to have fewer than twelve dates in their
decision-making schedule. In the end, the frequency of decisions and reports must strike a
balance. Having too many puts unnecessary strain on internal resources and may frustrate
markets if there is regularly too little new information to warrant reviewing economic
conditions and policy choices. Having too few decision dates risks avoiding the discipline of
confronting the evolving evidence and providing a clear interpretation, and risks delaying
policy action past the point where it is clearly called for.
It is important when choosing at fixed timetable for decisions and communications with
markets that it be made clear that there is nothing to stop the MPC from acting at other times
and communicating the nature and reasons for these actions, if extraordinary circumstances
arise. This cannot be a regular occurrence, or the benefits of the fixed timetable will be
eroded, but markets will understand that the MPC must be free to act when necessary under
extraordinary circumstances. It is in everyone’s interest that monetary policy be conducted
well.
Although a schedule should not be allowed to compromise good monetary decisions, there
are important advantages to having fixed decision dates and reports. Markets like
predictability of process. Having a fixed timetable for policy decisions and public discussion
focuses the attention of all players on the underlying issues at the same time and with the
same data. Commentators, both from markets and from the academic community, will debate
what the policy authority should do, listen to what is said about what was decided, debate
whether it was the right action, and then move on. Both sides can gain from this. It is
important to remember that markets are there to provide goods and services and, while the

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monetary policy environment can be an important consideration for at least the timing of
resource allocation decisions, it would be unfortunate if markets felt it necessary to focus on
these issues all the time, rather than their core businesses.
The policy authority also benefits from the fixed timetable, since there is no need to respond
formally to every piece of new information. It is also helpful that there is the discipline of
responding and providing commentary at each decision date. Even when no change of policy
stance is necessary, and perhaps especially when that is so early on in the learning process, it
is important that the MPC communicates to the markets why that is so. Without the discipline
of fixed dates, it might be tempting to wait until there is something more to do and say. Or,
possibly worse, it might be tempting to react to every new development, without the benefit
of careful thought. The fixed timetable also provides useful discipline for the internal
communication process; nothing focuses an organization better than the need to put
arguments on paper for release to the public.
It is also helpful for policy makers to get responses from the markets at these specific times.
At the least, contrary views can help define the research agenda. Issues of disagreements on
the facts can be dealt with relatively easily. Issues of interpretation are more difficult, but the
policy maker must always be ready to engage in the debate, if by doing no more than
repeating consistently the story that blends the economic conjuncture (economic conditions
as revealed in the data), the vision of how the economy operates and how policy decisions
impact on that economy, and how the decisions taken therefore fit with the objectives of the
IFT regime.
Let us now consider what information the MPC needs to make policy decisions. For virtually
every country entering into an IFT regime, the starting point must be a world economic
outlook, with special attention to economic conditions in the economies of important trading
partners and sources of capital. It is by no means necessary to develop such an outlook
internally, but members of the Staff must be assigned to monitor and report on external
conditions and to provide a forecast of the implications for trade and prices. Special attention
must be given to oil prices or significant commodity prices, depending on what is important
for the domestic economy. Significant capital account developments, linked to developments
in private and public debt or to major foreign direct investments, may also be important to
the outlook generally and domestic investment demand monitoring. To understand
developments with respect to the currency, there will have to be some consensus on the
underlying real exchange rate path. This is easy to say, but not so easy to obtain.

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